Wednesday, November 18, 2009

Spending Money from a Defined Contribution Plan without the 10% penalty

Thanks to John James,

Special Solutions was founded by John James to assist families with special needs family members as they seek to provide for the future. As a Licensed Advocate for Protected Tomorrows®, John is uniquely prepared to guide families in developing a life plan for the family member.

Normally, distributions made before the participant attains age 59-1/2 are called “early distributions,” and are subject to a 10% penalty tax. The tax does not apply to early distributions upon death, disability, annuity payments for the life expectancy of the individual, or distributions made to an ex-spouse by a QDRO.

The tax Reg (72)(t)(2)(C) states that when you take money out of a qualified plan in accordance with a written divorce instrument (a QDRO), the recipient can spend any or all of it without paying the 10% penalty.

Let’s take a look at what happens when the ex-spouse receives the 401(k) asset. There are some specific rules to be aware of. Here’s an example.

Sarah was married to an airline pilot who was nearing retirement. They were both age 55. There was $640,000 in his 401(k) and the retirement plan was prepared to transfer $320,000 to her IRA.

She could transfer the money to an IRA and pay no taxes on this amount until she withdraws funds from the IRA. But Sarah’s attorney’s fees were $60,000 and she needed another $20,000 to fix her roof. She said, “I need $80,000.” Because the 401(k) withholds 20% to apply toward taxes on a withdrawal, Sarah asked for $100,000. After the 20% withholding, she had $80,000 in cash and $220,000 to transfer to her IRA. She was able to spend the $80,000 without incurring a 10% penalty on the $100,000, which saved her $10,000 in penalties.

After the money from a pension plan goes into an IRA, which is not considered a qualified plan, Sarah is held to the early withdrawal rule. If she says, “Oh I forgot, I need another $5,000 to buy a car,” it is too late. She will have to pay the 10% penalty and the taxes on that money.

It is important to understand the difference between rolling over money from a qualified plan and transferring money from a qualified plan. The Unemployment Compensation Amendment Act (UCA), which took effect in January 1993, stated that any monies taken out of a qualified plan or tax-sheltered annuity would be subject to 20% withholding. This rule does not apply to IRAs or SEPs.

In other words, if money is transferred from a qualified plan to an IRA, the check is sent directly from the qualified plan to the IRA. In a rollover, the funds are paid to the person who then remits the money to an IRA. A payment to the person, whether or not there is a rollover, is subject to the 20% withholding. Only a direct transfer avoids the withholding tax.

This is a great planning tool when clients have a need for cash and there is no other way to get it.

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